Monday, February 13, 2006

Picturing Financial Instruments

For my current writing project, I'd find it useful to develop a rough taxonomy of types of financial instruments. In particular, I'd like a graph clearly distinguishing securities, from commodities futures, from the sorts of claims traded on an prediction market. I want, in other words, something like a Nolan Chart for financial instruments. But I've not yet figured out what to put on the axes of such a Financial Instruments Chart.

To describe the problem more accurately, I have only some tentative ideas about what to put on the axes of a Financial Instruments chart. First, I know that I want axes that will allow me to clearly separate securities, commodities futures, and prediction market claims. Second, I'm pretty sure that the familiar "risk/return" ratio won't help on this chart.

Third, It seems likely that one axis should convey this fundamental distinction between securities and commodities futures: Securities markets create wealth by making capital available for productive purposes, whereas commodities futures markets preserve wealth by offering hedges against losses. All investors can gain in a rising securities market, just as all may lose in a sinking one. Futures markets, in contrast, pit each trader against another; no one trader can profit except at the expense of another, less predictive one. Securities markets amass wealth; futures markets transfer it.

On that view, one axis of the putative chart would convey whether a market offers positive-sum or zero-sum trading. (I here refer solely to intra-market effects; even futures markets, thanks to their useful hedging functions, offer to increase net social wealth when put in the context of a larger market.) That helps to distinguish securities from commodities futures and prediction market claims.

But, crucially for my project, prediction market claims would fall quite near commodities futures on the "positive sum v. zero-sum" axis of the financial instruments chart. How, then, to distinguish prediction market claims from commodities futures ones? I've got three ideas.

Shooting from the hip, I've hit on a couple of distinguishing features. First, prediction markets serve important expressive functions. Traders on such markets stake not just money, but their reputations and worldviews. Those who hedge on futures markets, in contrast, say little more than, "I think this instrument will counterbalance financial risks that I run in other markets." Second, prediction markets generate significant positive externalities. We care about claim prices not so much because they presage the future price of commodities sales, but because they quantify the current consensus about ongoing debates.

But, on reflection, I've shot some holes in those two candidates. A prediction market does not require its traders to trade expressively. They might trade for mere money, too. And futures markets' price-finding functions represent useful externalities, too.

I thus favor a third way to distinguish between prediction markets and futures markets: Prediction markets probably would not, and certainly need not, serve commercially significant hedging functions.

Even small-stakes and play money prediction markets do pretty well at quantifying the current consensus. Theory suggests that they would do better were some or more money at stake. Still, though, a real-money prediction market could serve important expressive and predictive functions even far short of the sort of capitalization required for the sort of significant commercial hedging that futures markets provide. Happily for this proposed way of distinguishing prediction markets from futures markets, a prediction market that hosts little hedging would by default offer almost pure expression. All who trade on such a prediction exchange would do so by dint of their beliefs—not merely because they aim to safeguard their portfolios.

What do you think? Would a chart like the one below prove useful?

Financial Instruments Chart

expression | prediction
| claims
| securities
hedging | futures
zero-sum positive sum


Jason Ruspini said...

Very interesting! -- while thinking about the legality of different markets yesterday, i considered a similar taxonomy. One axis was the "official" purpose: 1) capitalization (stocks & bonds), 2) risk-sharing (futures and insurance), 3) information-seeking (a new, but exciting type - information is not a by-product). Another was specific trader motivation: a) money, b) reputation, c) intrinsic value, i.e. entertainment, the thrill of trading.

I've also thought about the positive/zero/negative(?) sum axis before, specifically comparing it to Mancur Olson's exclusive & inclusive groups.. and that is the direction of my passion.. it's not that i'm for hedging, it just tends to make markets more "fit", especially when there are hedgers with opposite needs, as is the case with taxes and subsidies -- and we have only recently gained the powers of communication to aggregate the more-or-less infinitesimal fiscal risks.

Somewhat eerily - before reading your post - i printed out one of your old papers and read it on the subway on the way home tonight. Like gambling, legislation-linked markets may face heavy resistance, but then they'll just be pushed overseas.

Emile Servan-Schreiber said...

You suggest in passing that "theory suggests" that real-money prediction markets should be more accurate that play-money markets. It should be noted also that in practice, whenever direct comparisons have been performed, no such advantage has been observed.

Tom W. Bell said...

Jason: Reading my old papers *can* make a fellow feel strange, I hear. I hope you were sitting down during your subway ride.

But, seriously, I like the way you divvy up markets. I'm not sure you describe axes so much as categories, though--something that would best fit on a table.

Emile: The most careful of my sources would, I think, concede that we lack conclusive proof that prediction markets consistently outperform experts. But I don't think they would concede we have the sort of "direct comparisons" you allude to. The problem, from an experimental viewpoint, is that we lack a control group. Still, though, we surely have enough information to support further use of prediction markets. They don't seem to do any harm and they probably do much good.

Chris Hibbert said...

It's hard to place Prediction Markets on the hedging scale. It's true that all current markets are low enough volume that you can't actually hedge any relevant exposure, but Robin Hanson included the goal of supporting hedging in all his early writings on the subject.

I like the zero sum distinction, but as you noted, the implication that the institution itself is zero sum is wrong. Maybe we should look for a different term for this. The point we're making is the one you stated: holding (and trading) equity vs. holding (and trading) exposure. I think using those terms would be better, and you can separately explain the implications: in one case the underlying asset grows with the economy, and traders decide which to own, while in the other, they trade exposure (risk) and whenever someone gains positive exposure, someone else is gaining negative exposure. (Hmmm, that's interesting: if all the commodities futures are settled before close, some parties still have exposure, it's just not commoditized.)

There's another important distinction: equities represent ownership, and are open-ended. commodities and prediction markets have a limited term, and their value is definitely decided at the closing date.

Another distinction between commodities futures and equities is that far more futures are traded than there exist underlying assets. With Prediction markets, there aren't any underlying assets to be represented. Perhaps that's the real, interesting distinction: PMs don't have an underlying asset that's traded separately.